global trade and finance

7/29/2019 global trade and finance

1/256

1Module 1

FOREIGN TRADE MULTIPLIER

Unit Structure :

1.0 Objectives1.1 Introduction of Foreign Trade Multiplier1.2 Income determination in a multiplier in a closed economy1.3 Foreign Trade multiplier in an open economy1.4 Foreign Repercussion1.5 Introduction of the concepts External and Internal balance and

Role of Monetary and Fiscal Policy1.6 Expenditure Changing policies1.7 Expenditure Switching policy1.8 Introduction of Policy Mix1.9 A case for Monetary and Fiscal Policy Mix1.10 Meades Model1.11 Mundells Model1.12 Mundell-Flemming Model1.13 Summary1.14 Questions

1.0 OBJECTIVES

1. To understand the concept of Foreign Trade Multiplier2. To know the income generation process through multiplier in a

closed economy.3. To know the income generation process through the foreign

trade multiplier in an open economy.4. To study the rate of foreign repercussions on the income

generation process through the foreign trade multiplier in anopen economy.

5. To understand the concept of External and Internationalbalance and Role of Monetary and Fiscal Policy

6. To study Expenditure Changing Policy7. To study the Expenditure Switching Policy8. To understand the concept of Policy Mix9. To study Monetary and Fiscal Policy Mix10. To study Meades Model11. To study Mundells Model12. To study Mundell and Flemming Model

1.1 INTRODUCTION OF FOREIGN TRADE MULTIPLIER:

The original idea of multiplier was given by R. F. Kahn, thismultiplier was Employment Multiplier. The Employment Multiplier


2/256

Mcom-glob 2

studies the effect of changes in employment on changes in incomeas per which the changes in income happens to be greater than theinitial change in employment. It works through employmentmultiplier.

Algebraically,

Y = ke EY stands for change in income. Ke stands for EmploymentMultiplier E stands for initial change in Employment.

Lord J. M. Keynes borrowed the idea of his InvestmentMultiplier from R. F. Kahns Employment Multiplier. The Post-Keynesian economists extended the Keynes multiplier meant forclosed economy to foreign trade multiplier meant for an openeconomy.

The Concept of foreign trade multiplier was given by Mr.Leighton.

1.2 INCOME DETERMINATION IN A MULTIPLIER IN ACLOSED ECONOMY :

In a closed economy the total national income is equal to thesum total of private spending ie C + I and the GovernmentSpending i.e. G. When national income is looked at from the angleof total expenditure, it represents the expenditure side of the totalnational income of the country.

Algebraically,

Y = C + I + G

Y stands for total national income. C Stands for total Consumptionexpenditure. I stands for total investment expenditure. G stands forGovernmental expenditure.

Since Government doesnt strictly follow the rules of economics itsrole gets omitted. Hence in a closed economy the total nationalincome will be equal to the sum of consumption and investmentexpenditure.

Algebraically,

Y = C + IC = f (Y)

Since consumption in an indigenous variable it depends upon totalnational income. As income rises consumption rises too but it risesat a diminishing rate

I f (Y)

Since Investment is an exogenous variable it is not a function oftotal national income.


3/256

Mcom-glob 3

Y = C + S

Y = C + I

C, C from both the equations get cancelled hence savings will beequal to investment and conversely investment will be equal tosavings.

Algebraically,

S = I

I = S

If we allow time period to exert its influence on savings andinvestment then it will bring about changes in savings andinvestment. The change in savings will be equal to change ininvestment and vice versa.

Algebraically

S = I

I = S

Keynes Multiplier depends upon the marginal propensity toconsume (MPC)

Algebraically,

K = f (MPC)

K stands for Multiplier.

f stands for functional relationship.

MPC stands for marginal propensity to consume. The Marginalpropensity to consume is equal to change in consumption uponchange in income i.e.

Algebraically,

Y

CMPC

There are two limiting cases to marginal propensity toconsume viz.

i) MPC is always positive ie it is always greater than zero.

ii) MPC will never be never be equal to 1Hence MPC will get sandwiched between zero and one to

two extremes.

Mathematically,

10Y

C


4/256

Mcom-glob 4

Y

CfK

Since Multiplier in a function of MPC the multiplier also hastwo limiting cases.

i) The Multiplier will always be greater than one.

ii) The multiplier will never be equal to infinity.

Mathematically,

1 < K S + M Expansion takes place

ii) I + X < S + M Contraction takes place


7/256

Mcom-glob 7

When we introduce the change then the equation will be asfollows:-

S + M = I + X

S stands for change in savings.

M stands for change in imports.I stands for change in Investment.

X stands for change in Exports.

The marginal propensity to saving ie S / Y determines change insavings which is designated as S while the marginal propensity toimport determines the change in imports.

which is designated as m hence the equation will be asfollows:-

(S + M) Y = I + X

XIms

Y1

The foreign trade multiplier is a function of marginal propensity tosave plus marginal propensity to import.

Kf sets designated as Foreign Trade Multiplier.

Kf = f (S + M)

Kf stands for Foreign Trade Multiplier.

f stands for functional relationship.

S stands for marginal Propensity to save.

M stands for marginal Propensity to import.

There is an inverse relationship between s + m and Kf. Smaller thes + m greater will the Kf. Conversely greater the s + m smaller willbe Kf.

Hence the formula of income propagation through foreign trademultiplier will be as follows:-

XImsY

1

MPMMPSKf

1

The value of MPS = 0.25

The value of MPM = 0.15

Substituting the values we get,

Y

M


8/256

Mcom-glob 8

5.240.0

1

15.025.0

1Kf

Y = Kf X

If exports increase by 200 ie from 300 to 500; I = 0

Y = 2.5 200 = 500YE1 = YE + Y

= 1000 + 500 = 1500

S = S Y = 0.25 500 = 125

M = m Y + 0.15 500 = 75

Figure 1.1

At the point of changed equilibrium level of national income

I + X = S + M

0 + 200 = 125 + 75

200 = 200

K = 4 in the closed economy while Kf = 2.5 in the open economy.

Kf < K because of two leakages i.e. savings and imports.

Check Your Progress:

1. Distinguish between foreign trade multiplier in a closedeconomy and in an open economy.

---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

E

E1

X

O YE YE1

YNational Income

S+M

X

X,M,I,S

Y

I+X

I+ X

I


9/256

Mcom-glob 9

---------------------------------------------------------------------------------------------------------------------------------------------------------------

1.4 FOREIGN REPERCUSSION

There are two countries taking part in the foreign trade. Oneis the reporting country and the other trading partner is the foreign

country. When exports of the reporting country rise the impliedmeaning is that the imports of the foreign country rise. As theexports of the reporting country rise it leads to increase in exportearnings. As the imports of the foreign country rise it will lead to fallin the income of the foreign country. As its income falls its importswill also fall which will have its repercussion on the exportingcountry ie on the reporting country. It is called as foreignrepercussion. It will reduce the size of the foreign trade multiplier ofthe exporting country.

Formula of Computation of the value of foreign trade multiplier,

2211

1MPMMPSMPMMPS

Kf

The subscripts 1 and 2 represent the Reporting Country andthe foreign country respectively.

MPS1 = 0.25; MPM1 = 0.15; MPS2 = 0.06; MPM2 = 0.04

Substituting the values we get,

0.040.060.150.25

1Kf

0.100.401Kf

0.50

1Kf

2

1

1Kf

Kf = 2

Y = Kf X

= 2 200 = 400

YE1 = YE + Y

= 1000 + 400 = 1400

Thus if we take into account foreign repercussion the value offoreign multiplier will get reduced and hence the new equilibriumlevel of national income will also get reduced from 1500 to 1400.\


10/256

Mcom-glob 10


1. What do you mean by foreign repercussions?

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

1.5 INTRODUCTION OF EXTERNAL AND INTERNALBALANCE

Under the pegged exchange rate system of IMF the membercountries of IMF faced the twin problem of maintaining the externalbalance and internal balance. The External balance dealing withmaintaining the balance of payments equilibrium while the internalbalance deals with maintaining full employment and price stability.

When a country is to attain two targets simultaneously it is requiredto use two policy instruments simultaneously. Thus to attain theinternal and external balance the use of monetary and fiscal policysimultaneously is called for.

1.5.1 CONCEPTS

External Balance and Internal Balance:-

External balance refers to achieving equilibrium in thebalance of payments.

Internal balance refers to achieving full employment withprice stability.

Generally a country assigns a priority to maintain internalbalance by maintaining full employment level of employment andprice stability. But when a country witnesses persistentlyfundamental or structural deficit in the balance of payments theconcerned country has to switch over its priority from maintaininginternal balance to maintaining external balance.

The cyclical or seasonal type of disequilibrium in the balanceof payments is a transitory phenomenon which can be reversed or

corrected automatically while it is not the case with regard tostructural or fundamental disequilibrium in the balance of paymentsespecially when it persists for a long time. Then it gets transformedinto a chronic phenomenon. Hence it is the fundamentaldisequilibrium in the balance of payments that needs adjustment.

When a country has several objectives to be achieved thecountry is bound to use several policy instruments. Hence theproblem of Assignment comes into being. The problem of pairingtargets and instruments gets referred to as the problem of


11/256

Mcom-glob 11

Assignment. The Assignment problem is a problem of assignmentof policy instruments to achieve the targets.

1.6 EXPENDITURE CHANGING POLICIES

The expenditure changing policies are referred to as the

expenditure adjustment policies. The expenditure change oradjustment can be brought about either by reducing or increasingthe expenditure. The expenditure changing policies bring aboutchanges in income. Thus the expenditure changing policies canalso be called as income changing policies. The deficit in thebalance of payments arise due to increase of imports and decreaseof exports or both. To curtail imports you must curtail yourexpenditure. Hence expenditure reducing policy pertains tocorrecting the deficit in the balance of payments. On the other handexpenditure increasing policy pertains to correct the surplus in thebalance of payments. By following the expenditure increasing policy

you can increase your imports thereby it reduces your surplusbalance of payments. Out of deficit and surplus balance ofpayments it is the deficit in the balance of payments whichbecomes a more serious problem to deal with. Hence theexpenditure changing policy goes with the name of expenditurereducing policy. The monetary and fiscal policies are used to bringabout reduction in expenditure to cure deficit in the balance ofpayments.

1.6.1 MONETARY POLICY

The monetary policy is the policy of the monetary authority ofthe country. The monetary authority of the country is the CentralBank of the country. In case of India, the Reserve Bank of India isthe Central Bank of India. The monetary policy deals with themonetary management ie controlling the supply of money andcredit of the economy through the use of monetary instruments.The central bank of the country has got so many instruments at itsdisposal to control the quantum of money and credit of which twoare very important viz i) Bank Rate and ii) Open Market Operations.

Bank Rate is an official minimum rate of the Central Bank ofthe country at which it advances short term loans to commercialbanks. The Bank Rate policy means raising or lowering down of the

bank rate depending upon the situation.Open market operations mean buying or selling of the

Government securities in the open market.

The Bank Rate and open market operations go hand inhand.

The Central Bank of the country follows two types ofmonetary policy Viz.

i) Contradictory monetary Policy and


12/256

Mcom-glob 12

ii) Expansionary monetary Policy

The contradictory monetary Policy is also called as tightmonetary Policy. When a country suffers from deficit in the balanceof payments it follows tight monetary policy. It raises the bank rate.When the bank rate is raised by the Central Bank the commercialbank finds it very difficult to get short term advances from thecentral bank because loan from central bank becomes costlier.There is generally a 2% difference between the bank rate andmarket rate. The market rate is a rate which is charged by thecommercial banks to their customers for advancing loans. Whenthere is a hike in the market rate of interest getting loans fromcommercial banks becomes costlier for the banks customers whichcurtails money supply.

Simultaneously the central bank of the country sellsGovernment. securities in the open market. Those who buy thesecurities issue cheques to the Central Bank on their accounts with

the commercial bank. The central bank thus withdraws cash fromthe commercial bank which controls their habit of creation ofmultiple credit.

Thus the central bank of the country by following tightmonetary policy reduces money supply which leads to reduction inexpenditure which in turn reduces imports and thus ultimatelybrings about improvement in the balance of payments. (Theincrease in the rate of interest will lower down investment) In caseof surplus balance of payments the central bank follows easymonetary policy in which the rate of interest gets lowered downwhich leads to increase in investment and income which increases

imports. In case of tight monetary policy due to hike in rate ofinterest the inflow of foreign capital takes place which also rendersa helping hand to correct the deficit in the balance of payments.Conversely when the central bank follows easy money policy therate of interest falls which leads to flight of capital from theconcerned country to foreign countries which renders a helpinghand to correct surplus balance of payments.

Monetary policy also helps to maintain internal balance.When the central bank follows easy money policy the rate ofinterest is lowered down. It accelerates investment which leads to

generation of income and employment through multiplier. It leads torise in price level. Thus easy money policy of the central bankmaintains internal balance through maintenance of full employmentand price stability. The vice versa situation takes place when thecentral bank follows tight money policy.

1.6.2 Fiscal Policy:- The fiscal policy is also used as aninstrument of maintaining both internal and external balance. Theterm fiscal is derived from the Greek word fisc which meansbasket. The Governments basket is its treasury. Thus fiscal policyis the policy of the Government with regard its treasury. It is also


13/256

Mcom-glob 13

called as Budgetory Policy of the Government which deals withrevenue and expenditure of the Government ie the public bodies.

According to Arthur Smithies fiscal policy is a policy under whichthe Government. uses its revenue and expenditure in such a wayas to produce desirable effects avoiding undesirable effects on thenational economy as regards production, income, employment and

balance of payments. Fiscal Policy uses two very import fiscal toolsto bring about defined changes i.e. to maintain internal and externalbalance viz taxation and expenditure like monetary policy fiscalpolicy is also of two types viz.

i) Contractionary fiscal Policy and

ii) Expansionary fiscal Policy.

To reduce deficit in the balance of payments theGovernment follows concretionary fiscal policy. On the one handGovernment reduces public expenditure and on the other handGovernment raises tax rates of both the direct taxes and indirect

taxes. The reduction in Government. expenditure will reduceincome and employment through multiplier in the reverse gearwhich will also reduce price level. It will control inflation and willmaintain internal balance. It is also called as an anti-inflationaryfiscal policy. It will also maintain external balance by improvingbalance of payment situation of a country. By reducing income itwill reduce imports because import is a function of income. M = f(Y) There is a positive and direct relationship between income andimports. When income decreases it brings about a correspondingdecrease in imports. By decreasing prices of goods and services,our country becomes a good country for the foreigners to buy the

things from and hence exports accelerate leading to increase inexport earning which leads to improvement in balance of payments.

An expansionary fiscal policy is followed when the countrywould like to reduce surplus in the balance of payments. TheGovernment. expenditure increases and the tax rates of both directand indirect taxes are reduced. It leads to increase in income andemployment through multiplier effect. It leads to increase inconsumption, price level also rises. A country becomes a very goodcountry for the foreigners to sell their goods into the reportingcountry. Thus imports accelerate while exports contract and as

such the surplus in the balance of payments get reduced. Thus acountry maintains external balance. It also maintains internalbalance of maintaining employment income and price level toequilibrium position.

However monetary policy is preferred for maintainingexternal balance while fiscal policy is preferred for maintaininginternal balance. Since expenditure reducing policy brings about apositive effect on balance of payments while expenditure increasingpolicy brings about a negative effect on balance of payments the


14/256

Mcom-glob 14

expenditure changing policy gets colored by its bright side ie theexpenditure reducing policy.

1.7 THE EXPENDITURE SWITCHING POLICY:-

At the outset let us make it very clear that the expenditureswitching policy means expenditure increasing policy. The second

very important point about expenditure switching policy is that theexpenditure switching policy works through changes in relativeprices. The mechanism through which changes or adjustment in therelative prices can be brought about in the changes in exchangerate. The changes in the exchange rate bring about depreciation orappreciation. Depreciation or devaluation means lowering down ofthe external value of the domestic currency in terms of foreigncurrencies. The meaning and results of both depreciation anddevaluations are same ie decrease in the price level of the goods inthe domestic country which cheapens our goods for the foreignersbecause of which our exports accelerate. Simultaneously it curtails

our imports because of relative costliness of the foreign goods.Thus depreciation or devaluation improves balance of payments byreducing deficit. However Devaluation works effectively whenMarshall-Lerner condition is satisfied i.e. the elasticity of Exportsplus the elasticity of imports must be greater than one. The viceversa will be the situation in case of appreciation. When there is anappreciation in the foreign exchange rate it raises the Price leveldomestically and the country becomes a good country to sell theforeign goods into our economy. Relatively the foreign goodsbecome cheaper. Thus it contains our exports and accelerates ourimports. It reduces the surplus in the balance of payments.

The depreciation is automatic which work under fixedexchange rate. The devaluation in voluntarily resorted to by theGovernment. It works under flexible exchange rate system.

The direct controls can also be used as an instrument ofexpenditure switching policy. By banning the imports of foreigngoods the consumers will be directed to spend more in buyingdomestic goods only.

The direct controls can be of two types:-

i) Commercial Controls and

ii) Financial Controls.

i) Commercial Controls:- Tariffs, import quotas are some of theexamples of commercial controls. Tariffs mean import and exportduties. When import duties are raised it restricts our imports. Whenexport duties are reduced it accelerates our exports. The importquotas also reduce our imports. Thus commercial controls correctdisequilibrium in the balance of payments.

ii) Financial Controls:- Financial Controls includes the use ofdevices like exchange control and multiple exchange rates. When


15/256

Mcom-glob 15

exchange controls are in force the export earners are forced tosurrender 40% of their foreign exchange earning to the foreignexchange authority of the country i.e. the central bank of thecountry against the domestic currency at an official minimum rate.Then they are free to sell the remaining 60% of foreign exchange inthe foreign exchange market at the free market rate. The country

also follows multiple exchange rate system i.e. changing differentrate of exchange against different commodities.

The policy of direct control is meant for short term and notfor long term it may spread harmful effects on the nationaleconomy.


1. Explain the following terms:

a) Expenditure switching policy

b) Expenditure changing policies

2. Differentiate between Internal and external balance.

3. Write notes on:

a) Monetary policy

b) Fiscal policy

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

1.8 INTRODUCTION OF POLICY MIX

To know the problem of policy mix we must know theefficacy of the monetary policy and the Fiscal Policy. The highestlimitation of monetary policy in the context of the underdevelopedcountries arises from the fact that the money market, the capitalmarket and the financial institutions are highly unorganized in theseunderdeveloped countries which seriously limit the ability of themonetary authority to control the monetary variables. It is not in aposition to expand and contract the money supply in the economy.It cant control the unorganized sector. The agricultural sector is the

unorganized sector which depends to a large extent for its loanrequirements on the indigenous banks and the money lenders. Thissector still remains outside the orbit of the banking sector on whichthere is no control of the central bank of the country. The objectivesof the monetary policy are not quite clear. These objectivescontradict each other. For example economic growth and pricestability objectives of monetary policy contradict each other. In thewake or economic development inflation is bound to take place.

And if you stick to price stability then economic growth cant takeplace rapidly.


16/256

Mcom-glob 16

The technique of control adopted by the monetary authoritiesof the underdeveloped countries is less effective. The Bank Ratefails to restrict credit expansion since the interest rate structure isnot sensitive to the bank rate. The underdeveloped nature of themoney and capital markets restrict the ability of the open marketoperations to control credit. The variable reserve ratio policy has a

greater chance of success as compared to the bank rate policy andthe open market operations since the central bank can immobilise apart of the assets of the commercial banks and thus restrict theirpower to expand credit. However, in many developing countriescommercial banks hold excess reserves. Even if the central bankraises the cash reserve ratio their capacity to create multiple creditdoesnt get restricted. In some of the developing countries asubstantial part of the banking sector is in the hands of the foreignbank branches in these countries. They rely on the resources fromtheir head offices in the foreign countries. Because of the limitedsuccess of the quantitative credit control measures of the monetary

policy the underdeveloped countries have switched over theiremphasis to qualitative credit control measures. These measurehave been frequently adopted to restrict hoarding of food grainssugar, oil etc. But they have not been successful in accomplishingmuch. It is because I) there is not check on the actual use of thecredit. Loans taken for productive purposes are diverted tounproductive purposes. ii) Huge stocks of essential food grains areaccumulated by the farmers themselves. These stocks never cometo the market place. (Either they keep it for self consumption or sellout in the villages.)

Fiscal Policy is a policy of the Government as regardsTaxation, Public expenditure and Public borrowing. Taxation, Publicexpenditure and Public borrowing are the three instruments ofFiscal Policy. Fiscal Policy is a part of general economic policy.Fiscal Policy uses its instruments in such a way as to producedesirable effects and to avoid undesirable effects. The objectives offiscal policy are directed towards achieving economic stability indeveloped countries and economic development in developingcountries.

The success of fiscal policy largely depends on a fairlyaccurate forecasting of the course of trade cyclical activity which is

a very difficult task. Even if we are able to know the future course oftrade cycle it is very difficult to know the impact of combination ofvarious instruments of fiscal policy on the different variables of theeconomic activity. Increase in public investment may cause adecrease in private investment because of rise in prices of factorsdue to keen competition from the Government. Fiscal Policy forachieving full employment may be made ineffective by risingwages. Fiscal measures may be effective only in curbingunemployment resulting from a deficiency in demand. A fiscalpolicy for curbing unemployment may create balance of payments


17/256

Mcom-glob 17

difficulties because additional income may be spent on importinggoods from foreign countries. Increase in Governmental spendingon public works during deflation and the decrease in the sameduring inflation may clash with other social and economicobjectives. A vigorous fiscal policy to combat depression maycause a vast increase in public debt which may make the debt

management extremely difficult.

As regards taxation which is the main instrument of raisingthe resources for undertaking the developmental projects theunderdeveloped countries face number of problems which are asunder:-

i) These countries try to raise the rates of the existing taxes andimpose new taxes. But there is a large non-monetized sector inthe developing countries. Therefore it is very difficult to assessthe income originating in this sector.

ii) The majority of the population in the developing countries is

illiterate such that they cant file the income tax returns.

iii) Through direct taxes the Government reduces the disposableincome of the people and thus restricts their capacities to buythe goods. Through indirect taxes Government raise the pricesof the goods. This also restricts consumption. There is a largescale tax evasion as regards direct taxes.

iv) The key to successful income tax is voluntary compliance on thepart of tax payers. This condition is not satisfied in thedeveloping countries.

As regards public expenditure which is the second mostimportant instrument of fiscal policy it is ever growing due to thegrowth of the Governmental functions. However there is a built ininflationary tendency in public expenditure. Secondly the marginalsocial benefits go on diminishing as the public expenditure goes onincreasing. Thus in the underdeveloped countries there are largenumber of free riders which geopardise the Governmental revenue.

Public borrowing is the third most important instrument offiscal policy. Public borrowing includes both the internal andexternal loans. These loans help the development process byfinancing the developmental projects and build up the repaying

capacity of the public authorities. However the continueddependence on the public borrowing especially external loansreduces the economic independence of these countries besidesintroducing uncertainty in the whole developmental process. Thebiggest disadvantage of foreign loans is that continued dependenceon them or a number of years increases the burden of repaying andservicing foreign debts as these are to be paid in foreign exchange.


18/256

Mcom-glob 18

1.9 A CASE FOR MONETARY AND FISCAL POLICYMIX

So as to iron out the limitations of both the monetary policyand fiscal policy, there is a need to have a judicious blend ofmonetary and fiscal policy. It will step up the effectiveness of both

the policies viz the monetary policy and the fiscal policy.During 1930s great depressions the importance of fiscal

policy was first recognized in the right perspective. Since then it hasbeen given increasing importance not only in the developingcountries but also in the developed countries. The role of deficitfinancing was duly recognized to raise the resources for economicdevelopment. Therefore though originally it was proposed tosupplement the monetary policy it has tended to supplant it. Theneglect of the monetary policy, the reckless monetary expansionand the consequent soaring trend of prices led to the loss ofconfidence in domestic currencies. This points to the necessity of

evolving a judicious blend of monetary and fiscal policies. The tightfiscal policy combined with fairly easy credit policy will place ampleresources at the disposal of the Government to finance publicexpenditure projects and it will induce the private investment whichwill add more quickly the output without borrowing.

1.10 MEADES MODEL

Meade has given his model of simultaneous achievement ofinternal and external balance with the help of the simultaneousapplication of expenditure adjustment and expenditure switchingpolicies. He was of the opinion that if both the policies are used

singly then it may lead to a conflict between the internal balanceand the external balance.

Figure 1.2

In the above diagram, Domestic Absorption i.e., expenditureis marked along X axis while Exchange rate is marked along Y axis.IB curve is a internal balance curve which slopes downward

Domestic Absor tion

ExchangeRRate

INFLATION &SURPLUS

IE

IVUNEMPLOYMEN

T& SURPLUS

IIIUNEMPLOYMENT

& DEFICIT

IIINFLATION &

DEFICIT

X

Y

IB

EB


19/256

Mcom-glob 19

(negative slope) from left to right. It shows that as exchange ratedepreciates domestic absorption must rise so as to achieve internalbalance. EB curve indicates external balance. It is positivelystopped indicating that as exchange rate appreciates domesticabsorption must rise and vice versa so as to maintain externalbalance. The intersection between IB curve and EB curve takes

place at the point E which determines the internal balance andexternal balance simultaneously. In the diagram following fourzones are shown:-

1) Zone I shows inflation and surplus in the balance of payments.

2) Zone II shows Inflation and Deficit in the balance of payments.

3) Zone III shows unemployment and deficit in the balance ofpayments.

4) Zone IV shows unemployment and surplus in the balance ofpayments.

The above diagram shows how the two policy instrumentsshould be combined to achieve simultaneously internal andexternal balance.

Solution:- In case of Zone I a country has to follow appreciation inthe exchange rate so as to combat surplus in the balance ofpayments at the same time it has to follow contractionary fiscalpolicy to reduce domestic expenditure to combat inflation. In caseof Zone II a country has to follow devaluation i.e. reduction in theforeign exchange rate so as to combat deficit in the balance ofpayments. At the same time a country has to follow concretionaryfiscal policy to reduce domestic expenditure to combat inflation.

In case of Zone III a country has to follow devaluation and anexpansionary fiscal policy. In case of Zone IV a country has tofollow revaluation and an expansionary fiscal policy.

1.11 MUNDELLS MODEL

It was given by Robert A. Mundell. He was of the opinionthat in order to achieve internal balance and external balancesimultaneously there is a need to apply monetary and fiscal policysimultaneously. Internal balance refers to domestic balance ie fullemployment with price stability. External balance refers toequilibrium in the balance of payments. He highlighted the fixedexchange rate system so as to achieve equilibrium in the balanceof payments because in a freely fluctuating exchange rate systemexternal balance is automatically achieved. When external balanceis achieved it doesnt mean that internal balance is in equilibrium. Inorder to bring about internal balance it is necessary to reduceinflation and unemployment to zero. (There is a trade off betweeninflation and unemployment) In order to bring about external


20/256

Mcom-glob 20

balance there is a need to bring about equally between imports andexports ie debits and credits.

Expansionary monetary policy i.e. the cheap money policycan be resorted to by reducing the rate of interest. It will lead toincrease in the level of income and employment. It will alsoincrease imports as imports are the function of level of income.

M = f (Y)

Contractionary monetary policy i.e. the dear money policycan be resorted to by enhancing the rate of interest which will leadto reduce investment, income and employment. It will also lead toreduce imports ie it will reduce inflation and deficit in the balance ofpayments. Expenditure increasing policy consists of expansionarymonetary and fiscal policy i.e. reduction in the rate of interest andincrease in public expenditure.

Expenditure reducing policy consists of contractionary

monetary and fiscal policy i.e. increasing the rate of internal andreducing public expenditure.

Both these policies referred to as expenditure adjustment orchanging policy.

If a country faces the problem of internal and externalimbalance ie internally inflation and externally deficit in the balanceof payments then it is advisable that a country should followconcretionary monetary and fiscal policies.

Combining Monetary and Fiscal Policy

Under the pegged exchange rate system the Governmentsof the countries are unwilling to use exchange rate changes as apolicy instrument to bring about external balance because the I. M.F. procedure requires that a currency be devalued only when acountry suffers from fundamental disequilibrium the balance ofpayments. Hence the countries are left with the option to use onlytwo policy instruments viz. the monetary policy and the fiscal policyto bring about external balance and internal balance. Of these twoRobert Mundell has recommended the assignment of monetarypolicy for external balance and fiscal policy for internal balance.


21/256

Mcom-glob 21

Figure 1.3

Fiscal Policy is marked along X axis while monetary policy is

marked along Y axis. IB curve is an internal balance curve. EBcurve is an external balance curve. Both the curves are negativelysloped. It is assumed that monetary policy is more powerful inbringing about external balance hence EB schedule is flatter thanIB schedule. Point E shows the intersecting point at which bothinternal and external balance are simultaneously achieved. In thisdiagram four zones are shown which are as follows:-

1) Zone I which shows balance of payments surplus and inflation

2) Zone II which shows deficit in the balance of payments andinflation

3) Zone III which shows deficit in the balance of payments andunemployment

4) Zone IV which shows surplus in the balance of payments andunemployment.

Solution:- In case of Zone I expansionary monetary policy tocombat surplus in the balance of payments and concretionary fiscalpolicy to combat inflation will be adopted.

In case of Zone II a concretionary monetary policy andcontractionary fiscal policy will be adopted.

In case of Zone III a contractionary monetary policy andexpansionary fiscal policy will be adopted.

In case of Zone IV a expansionary monetary policy andexpansionary fiscal policy will be adopted.

However the fact remains that in number of countries of theworld the monetary policy and the fiscal policy are under the controlof separate authorities ie the monetary policy remains under thecontrol of the Central Bank of the country while the fiscal policyremains under the control of the Government.

IIIDEFICIT &UNEMPLOYMENT

IVSURPLUS &

UNEMPLOYMENT ISURPLUS &INFLATION

Fiscal Polic

IIDEFICIT &INFLATION

E

X

Y

IB

EB

O

MonetoryPolicy


22/256

Mcom-glob 22

1.12 MUNDELL FLEMING MODEL

Mundell and Fleming have given jointly their model in termsof IS, LM and BP schedules. They have extended the IS, LM modelto incorporate External Balance by way of incorporating B. P.Schedule.

IS schedule represents Investment and savings schedule

LM schedule represents Demand for and Supply of moneyschedule

BP schedule represents Balance of payments schedule

Figure 1.4

The intersection between IS and LM schedules determine

internal balance which is shown by the Point E at which rate ofinterest is of the order of OR0 and national income is Oyo sincepoint E lies above and to the left of BP schedule it shows that theeconomy is running a balance of payments surplus.

Under these circumstances if the economy would like toachieve both internal and external balance then it has three options

(a) (b)

Rate ofInterest Rate ofInterest

LMLM1

E1

IS

Y Y1

RR1

National Income

Y

BP

LME

R

IS

E

BP

National Income

O O

Y0

R0 E

BP

National IncomeX

Y

IS

Rate ofInterest

LM


23/256

Mcom-glob 23

(c) (d)

Figure 1.5

Diagram (a) shows appreciation in the foreign exchange rate suchthat BP curve shifts upward and passes through equilibrium point Eand intersects IS and LM curves. As such the internal balance andthe external balance are achieved.

Diagram (b) shows the central bank pursuing the expansionarymonetary policy by lowering down the rate of interest such that LMschedule shifts to the right and passes through IS and BPschedules thus at the point of intersection i.e. E1 once againinternal balance and external balance are achieved.

Diagram (c) shows the Government switches over to theexpansionary fiscal policy such that the IS curve shifts to the rightupward and passes through the intersecting point E1 as such onceagain internal and external balance are attained.

Diagram (d) shows the role of monetary and fiscal policy whenthere is a perfect capital mobility i.e. BP curve is a horizontalstraight line going parallel to X axis. Initial equilibrium is at E atwhich IS and LM schedules intersect each other with BP schedulegiven. When the central bank follows expansionary monetary policywhich shifts the LM schedule to the right leading to LM schedule.When the Government follows expansionary fiscal policy the IS

schedule. With the BP schedule given IS1 and LM1 schedulesintersect at the point E1 leading to establishing internal and externalbalance at a higher level with the national income increasing fromOY to OY1.


1. Explain how the problem of policy mix arises.

2. Write notes on the following models of policy mix:

a) Meades model

O

BP

Rate ofInterest

Rate ofInterest

LMLM1

E1

IS1IS

Y Y1

R

X

National Income

Y Y1

BP LM

E1

E

R1

R

Y

IS1IS

X

E

National Income

O


24/256

Mcom-glob 24

b) Mundells model

c) Mundell-Fleming model

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

1.13 SUMMARY

The original idea of multiplier was given by R. F. Kahn.

1. Lord J. M. Keynes multiplier was investment multiplier whichwas meant for closed economy.

2. Keynes multiplier is extended to open economy which getsreferred to as foreign trade multiplier.

3. The term foreign trade multiplier was given by Mr. Leighton.

4. Closed economy multiplier gets designated as K which is afunction of MPC.

5. Foreign Trade Multiplier is a function of MPS + MPM.

6. XIYms

1

1

7.MPMMPS

Kf1

8. Y = Kf X

9. If foreign repercussion is taken into account then,

2211

1

MPMMPSMPMMPSKf

10. Kf < K

11. The foreign repercussion will reduce the size of foreign trademultiplier which will also reduce the size of new equilibriumlevel of national income.

12. There are two types of balances viz.a) Internal Balance and

b) External Balance

13. Internal balance refers to maintaining full employment andprice stability.

14. External balance refers to achieving equilibrium in the balanceof payments.

15. Generally country assigns priority to maintain internal balance.


25/256

Mcom-glob 25

16. The problem of pairing targets and instruments gets referredto as the problem of Assignment.

17. There are two types of policies to bring about internal balanceand external balance viz.

a) Expenditure changing policies and

b) Expenditure switching policies.

18. The expenditure changing policies are also termed asexpenditure adjustment policies.

19. The expenditure adjustment policies are of two types viz.

a) The Monetary Policy and

b) The Fiscal Policy.

20. The expenditure switching policies work through changes inprice level.

21. The expenditure switching policies include devaluation andrevaluation.

22. Internal balance refers to achieving full employment with pricestability.

23. External balance refers to the equilibrium in the balance ofpayments.

24. Expenditure changing policies refer to the expenditureadjustment policies.

25. Monetary Policy and Fiscal policies are used to bring about

expenditure adjustment.26. Expenditure switching policy refers to expenditure increasing

policy.

27. Expenditure switching policy operates through changes inexchange rates and direct controls.

28. Monetary policy is a policy of the Central Bank of the country.

29. Fiscal Policy in the policy of the Government of the country.

30. Simultaneous achievement of the objectives requiressimultaneous adoption of the policies.

31. Meades model recommends the simultaneous achievement ofinternal and external balance with the help of simultaneousapplication of expenditure adjustment and expenditureswitching policies.

32. Internal balance is brought about by full employment with pricestability.

33. External balance is brought about by equalizing imports withexports.


26/256

Mcom-glob 26

34. Mundells model brings about the simultaneous internal andexternal balance by using monetary and fiscal policiessimultaneously.

35. Mundell-Fleming model brings about internal and externalbalance through the equality between IS, LM and BPschedules.

1.14 EXPECTED QUESTIONS

1) Explain the process of income propagation through foreign trademultiplier.

2) Explain foreign trade multiplier and bring out its globalimplications.

3) Write short notes on the following:-a) Closed economy multiplier.b) Open economy multiplier.c) Foreign repercussions.

4) Explain the role of expenditure changing policies in bringingabout internal and external balance.

5) Discuss the role of monetary policy in bringing about internaland external balance.

6) Discuss the role of fiscal policy in bringing about internal andexternal balance.

7) Write short notes on the following:-a) Expenditure Switching Policy.b) Expenditure changing policiesc) Monetary policyd) Fiscal Policy

8) Discuss Meades model of expenditure adjustment andexpenditure switching policies to bring about internal andexternal balance simultaneously.

9) Critically evaluate Mundells model of a mix of monetary andfiscal policy to attain internal and external balancesimultaneously.

10) Discuss Mundell-Fleming model.11) Write short notes on the following:-

i) Monetary Policyii) Fiscal Policy

iii) Expenditure Switching Policyiv) Mundells model.

2


27/256

Mcom-glob 27

Module 2

ECONOMICS OF INTEGRATION I

Unit Structure:2.0 Objectives

2.1 Introduction of the term Economic Integration

2.2 Causes of popularity of Economic Integration

2.3 Types of Economic Integration

2.4 Introduction of Protection and Trade liberalism

2.5 Concept and examples of Regional Trade Block

2.6 European Union (EU)

2.7 North American Free Trade Agreement (NAFTA)

2.8 Summary

2.9 Questions

2.0 OBJECTIVES

1. To understand the term Economic Integration

2. To know the causes of popularity of Economic Integration

3. To understand the various types of Economic Integration

4. To know the concepts of Protection and Trade Liberalism

5. To understand the meaning and types of Regional Trade Blocks

6. To know about European Union

7. To know about North American Free Trade Agreement

2.1 INTRODUCTION

To know economic integration it is desirable to know economicliberalization. Economic liberalization is a process whereby

structural reforms are initiated in the economy. Economicliberalization involves the following major changes:-

i) changes in the outlook

ii) Technological up gradation

iii) Changes in trade, fiscal, monetary, price and industrialpolicies

iv) Opening the economy for foreign investment

v) Delicensing and enhancing export incentives.


28/256

Mcom-glob 28

Economic liberalization attempts to remove restrictions andmake an economy global in its approach. Economic liberalizationand globalization go hand in hand. Economic liberalizationfacilitates global integration of open economies.

After Second World War, countries of the world followed thepolicy of protection so as to rehabilitate the war shatteredeconomies. But it led to adoption of a retaliatory policy on the partof other countries of the world. It is called as the policy of tit for tatwhich led to the lowering down of the volume of trade, loweringdown of competitiveness, efficiency, income and employment.Hence all these things triggered off the wave for speedyliberalization by reducing tariff barriers. It paved the way foreconomic integration among the countries of the region and alsoamong the countries of the world. When economic integration takesplace among the regional economic integration. On the other handwhen economic integration takes place among the countries of theworld it gets referred to as multilateral economic integration. E.U,NAFTA, ASEAN, OPEC, SAARC are some of the glaring examplesof regional economic examples while GATT which later on gotmerged into WTO are the glaring examples of multilateral economicintegration. A very important point to be noted in connection witheconomic integration is that economic integration entails someextent of political integration too if not full political integration.

2.1.1 CONCEPT

The Term economic integration has been interpreted indifferent ways. Some authors even include social and politicalintegration in economic integration.

As per some authors the mere existence of trade relationsbetween two or more independent national economies signifieseconomic integration.

As per some authors economic integration is a type of anarrangement which leads to removal of artificial trade barriers forexample tariffs between two or more independent economies.

Economic integration is a general term which covers severalkinds of arrangements by means of which two or more independenteconomies agree to come closer economically. By economicallyintegrating themselves in the form of a union they would like todiscriminate against goods produced by countries of the rest of theworld lying outside the economic union.

As per Timbergen economic integration is the creation ofmost desirable structure of international economy removing artificialbarriers to the optimum operation and introducing deliberately alldesirable elements of coordination or unification. While definingthe term economic integration he draws a distinction between twotypes of economic integration viz. positive and negative economicintegration. Positive economic integration refers to bring about


29/256

Mcom-glob 29

reforms in the existing institutional arrangement, checking out theneo policy to correct the market imperfections. On the other handthe negative economic integration refers to removal of artificialbarriers like tariffs on he movement of goods among the membercountries of the group.

Mr. Balasa defines economic integration as, a process andas a state of affairs. As a process it encompasses measuresdesigned to abolish discrimination between economic unitsbelonging to different national states; viewed as a state of affairs, itcan be represented by the absence of various forms ofdiscrimination between national economies.

While interpreting the term economic integration he draws adistinction between economic integration and economic co-operation. The nature of the difference is both quantitative andqualitative. Co-operation entails action leading to lessen theseverity of discrimination while economic integration is a process

which leads to adoption of measures which can be used for thesuppression of some form of discrimination. For example G.A.T.T.or W.T.O. are the examples of cooperation. It is an agreementbetween the member countries of the world about the trade policiesto be pursued in order to intensity the volume of trade among themember countries of the world while removal of trade barriers thetariffs and other non-tariff barrier is an example of economicintegration.

2.2 CAUSES OF THE POPULARITY OF ECONOMICINTEGRATION:-

Now a days economic integration is becoming more popularbecause of the mutual benefits which spring up from economicintegration. United we stand divided we fall. In economicintegration the economic activities of the member countries areharmonized, co-ordinated and unitedly operated.

Following are the reasons of the popularity of economicintegration:-

i) Widening of market:- By regional grouping or integration thedomestic market gets widened. There happens to be a movefrom domestic market to a regional market.

ii) Economies of scale:- Due to regional integration or groupingproduction takes place at a very large scale due tospecialization. Due to specialization economies of scale bothinternal and external spring up.

iii) High degree of specialization:- The regional integration leads towidening of market, large scale production, economies of scale(internal and external) which paves the way for a very highdegree of specialization. A micro-level specialization ie


30/256

Mcom-glob 30

specialization amongst the specialized items takes place whichgets referred to as high degree specialization.

iv) Optimum reallocation of resources:- Assuming full employmentwhen the market widens due to economic integration in order tocope up with the increased demand the country concerned hasto reallocate resources ie resources are withdrawn from highcost production and put in use to the low cost production.

v) Increase in the volume of trade: Due to reallocation of factors ofproduction the volume of production increases ie the volume ofproduction doubles.

vi) Changes in the cost price structure:- As per the modern theoryof foreign trade due to economic integration each membercountry specializes in the reduction of a commodity in which it isbest suited for which leads to production of a commodity at anextremely low cost of production which in turn leads to keepingthe price of the product extremely low.

vii) Mutual Benefits:- Due to regional economic integration mutualbenefits accrue to all the member countries of the group due tospecialization, changes in the cost price structure in the membercountries.

viii)Consumers Surplus:- Before economic integration consumersof the home country use to get the goods at a very highdomestic price. When regional economic integration takes placeconsumers get goods at a very low price due to import of goodsat a very low price without tariff. Thus it leads to increase in thereal income of the consumers which gets referred to as

consumers supply.

ix) Increase in efficiency:- Due to healthy competition among themember countries of the group efficiency in productionincreases.

x) Increase in standard of living:- Due to economic integration ahigh degree of specialization takes place due to whichqualititiveness increase. Not only quantity but also quality ofproduct increase due to which life style changes.

xi) Increase in economic development:- The increase in the volumeof trade leads to increase in per capita income and the standard

of living of the people. It is an indication of increase in the rate ofeconomic growth of the member countries.

xii) Overall increase in welfare:- All the above mentioned factors,pave the way for increasing the general welfare and well beingof the people of the member countries.

2.3 TYPES OF ECONOMIC INTEGRATION:


31/256

Mcom-glob 31

There are as many as five major types of economic integrationwhich are as follows:-

i) A group of countries making preferential Trading Agreements.

ii) F.T.A i.e. Free Trade Area.

iii) C. U. i.e. Customs Union.

iv) C. M. i.e. Common Market

v) E. U. i.e. Economic Union

i) A group of countries making Preferential Tradingagreements:- In this type of economic integration a group ofcountries come together and make tentative or temporarypreferential trading agreements among themselves to givepreferential treatment to each others goods. This is a loose type ofeconomic integration because this type of integration remainstemporary. The member countries of this group reduce tariffs on

imports of goods from each other while there is no change in theoriginal tariff policy followed by each member country of the grouptrading with rest of the countries of the world which are not themembers of the group. For example common-wealth PreferentialSystem of 1932. Great Britain and the member countries ofcommonwealth established among themselves a system of tradewhich was referred to as commonwealth Preference System. Asper this system the commonwealth countries reduced tariffs amongthemselves but allowed their high tariff rates to continue on theimports from rest of the world countries.

ii) F.T.A. i.e. Free Trade Area:- As per the title a group of countriesforming a free trade area bring about a free trade between them byremoving all the trading restrictions. They completely remove alltariffs on imports of goods from the member countries. However,each member country of the free trade area retains its autonomy inlevying tariffs on the imports from non member countries of theworld. The European Free Trade Area (EFTA) is a burning exampleof Free Trade Area.

iii) C. U. i.e. Customs Union:-

A customs Union is a free trade area plus a common policy of tariffs

adopted by the member countries in dealing with the imports fromthe non member countries of the world. A burning example ofcustoms union is E. C. ie the European Community. It was formedin 1958 by signing the treaty of Rome in 1957. By July 1, 1958 acustoms union was established among the original six members ofthe European Economic Community viz Belgium, France, FederalRepublic of Germany, Italy, Luxembourg and Netherlands.

iv) Common Market:-


32/256

Mcom-glob 32

A common market is a step higher than the customs union. Acommon market is a customs union plus free movement of factorsof production viz labor and capital within the common market areaor region. A common market retains the two common characterfeatures of a customs union viz i) free trade among membercountries by removing tariffs internally and ii) the member countries

follow the common tariff policy in dealing with non membercountries of the world.

A glaring example of common market is European EconomicCommunity which is also called as European Common Marketwhich was established in Jan. 1958 by signing the treaty of Romein 1957. It had original six members viz Belgium, France, FederalRepublic of Germany, Italy, Luxembourg and Netherlands.

The treaty of Rome required every member to.

i) eliminate tariffs, quotas and other barriers on intra-community

trade.

ii) devise a common internal tariff on their imports from countriesbelonging to rest of the world.

iii) allow free movement of factors of production within the EEC.

iv) harmonies their taxation and monetary policies and socialsecurity policies and

v) adopt a common policy on agriculture, transport and competitionin industry.

The EEC was expanded in 1973 with the inclusion of United

Kingdom, Denmark and ireland. Greece joined the EEC in 1981.Spain and Portugal joined the EEC on 1st January 1986. Austria,Finland and Sweden joined the EEC afterwards and as such themembership of EEC became 15.

The common market is an advanced stage of customsunion. It provides a free market for goods belonging to all themember countries. It facilitates the mobility of factors of productionamong the members of the community. It means factors ofproduction viz labour, capital and enterprise can switch on to anymember country to EEC which they can find most profitable due to

which efficiency and productivity increase.v) E. U i.e. Economic Union:-

The Economic Union is still an advanced stage of economicintegration. The Economic Union is a common market plusharmonization of national economic policies viz monetary and fiscalpolicies.

An economic union can be defined as an economicintegration which leads to monetary union. The member of the


33/256

Mcom-glob 33

economic union chalk out common rules embodying things liketaxation, economic legislation foreign trade, agriculture, transportbalance of payments, fiscal and monetary policies, social andeconomic welfare etc.

The glaring example of economic union is E. U. ie European

Union viz Benelux ie Belgium, Netherlands and Luxembourg.

vi) ECM or EEC i.e. European common market or EuropeanEconomic Community- An economic union is a case ofabsolute economic integration. It means it is a completeeconomic integration of group of countries.


1. What do you understand by Economic Integration?

2. Give the reasons of popularity of Economic Integration.

3. What are the different types of Economic Integration?

-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2.4 INTRODUCTON OF PROTECTION AND TRADELIBERALISM :

After two world wars countries of the world thought it wise tohave collusion instead of collision. Countries of the world realizedthat Regional Co-operation had become the sine-qua-non of thedevelopment of the trade policy so as to trigger off the way forspeedy rate of economic development. An important theoreticalproblem of commercial policy regarding the terms and conditionson which imports and exports of commodities and services are allallowed is that of free trade versus protection. The problem iswhether the Government should allow imports and exports withoutrestrictions of any kind i.e. free trade, or it should impose tariffs and

other non-tariff restrictions on trade i.e. protection. In other wordsfree trade refers to the trade that is free from all artificial barriers totrade like tariffs, quotas, exchange control etc. Protection on theother hand refers to the Government policy of according protectionto the domestic industries from foreign competition.

The following are some of the demerits of the policy of protection:-

i) Protection is against the interest of the consumers as theconsumers get things i.e. goods and services at a higher price(as the cost of production being higher)


34/256

Mcom-glob 34

ii) From the point of view of the consumers there is a lack ofvariety and the choice and the quality.

iii) The producers and the sellers become less quality conscious.

iv) It encourages domestic monopolies.

v) It discourages innovation

vi) It leads to corruption.

vii) It reduces the volume of trade

viii)It leads to uneconomic utilization of world resources.

ix) Above all protection leads to retaliation i.e. the competitiveretaliation. The neighboring countries start adopting the policy,Tit for tat.

In the wake of globalization the cross boarderinterdependence is progressively increasing which leads toprogressive trade liberalization.

Following are the arguments for Trade liberation.

i) It leads to most economic utilization of productive resources ofthe world because a country specializes in the commodity inwhich it is best suited for ie it can produce the commodity mostcheaply and it exports the same. In turn it imports from othercountries these goods which it can produce most dearly.

ii) It leads to division of labors, specialization efficiency, economiesof scale, savings of the cost of production etc.

iii) It leads to intense competition. The inefficient producers are

either compelled to improve or to quit.

iv) It leads to breaking of the domestic monopolies.

v) It benefits the consumers to enjoy consumers surplus i.e.getting the goods and services at the lowest prices. They enjoythe variety, quality and choice.

vi) It widens the volume of trade.

The world is becoming narrower and narrower because ofglobal market. The grand success of European Union i.e. theEuropean Economic Community i.e. the European Common Market

has given impetus towards a growing trend of formation of regionaltrading block and retaining the existing regional trading blocks. It isnot only on the part of the developed countries but also on the partof the developing countries.

Economic integration of developing countries has beenadvocated by many economists as a means to accelerate theireconomic development and strengthen their trading and bargainingpower vis--vis the developed economies. The United NationsConference on Trade and Development (UNCTAD) felt Regionaleconomic groupings or any other form of economic co-operation


35/256

Mcom-glob 35

should be promoted among developing countries as a means ofexpanding their intra-regional and extra-regional trade andencouraging their economic growth. Trade expansion, economicco-operation and integration among developing countries is animportant element of an international development strategy. Itwould make an important contribution towards their economic

development.

The domestic market of number of developing countries islimited by the low per capita income. It is but natural that it comes inthe way of achieving economies of scale (both internal andexternal) and industrial development. It is hoped that the increasein the size of the market due to regional economic integration willtherefore, remove this obstacle. These developing countries shouldtherefore prefer regional economic grouping.


1. Differentiate between Protection and Trade Liberalism.

--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2.5 CONCEPT OF TRADE BLOCK

A Trade block is a cluster of nations meant for regionalism. It isa free trade area which removes all the obstacles to trade (tariffsand non tariffs) among themselves. It is a custom union which not

only removes obstacles to intra-regional trade but also follows acommon trade policy towards rest of the world countries ie with thenon member countries. In case of a regional trading block likecommon market there is not only a free movement of goods andservices but also a free movement of factors of productionregionally. In case of a perfect trading block like economic unionthere is a retention of all the feature of the previous types ofregional trading blocks plus there is a harmonization of nationaleconomic policies viz. monetary and fiscal policies. The economicunion may switch over to have its own common currency such thatregional trading block can also be called as common currency

block.We are going to study the five main types of regional trading blockswhich are as follows:-

(i) E. U. i.e. ECONOMIC UNION

(ii) NAFTA i.e. NORTH AMERICAN FREE TRADE AGREEMENT

(iii) APEC i.e. ASIA-PACIFIC ECONOMIC CO-OPERATION

(iv) ASEAN i.e. ASSOCIATION OF SOUTH EAST ASIANNATIONS


36/256

Mcom-glob 36

(v) SAARC i.e. SOUTH ASIAN ASSOCIATION FOR REGIONALCO-OPERATION

2.6 ECONOMIC UNINO (E.U.)

Economic Union (E.U.) is also known by several other names viz.E.E.C. which stands for European Economic Community.

E.C.M. which stands for European Common Market.

E.C. which stands for European Community.

The origin of Economic Union goes back to the signing of thetreaty of Paris in April 1941 by Germany, Italy and Netherlandsleading to the setting up of the European Coal and SteelCommunity (ECSC) Afterwards Europe made a comprehensiveattempt in the realm of economic integration in forming theEuropean Economic Community (EEC) on 1st January 1958 bysigning the treaty of Rome on March 24, 1957 by six WesternEuropean countries known as Inner Six viz. France, Germany,

Italy, Belgium, Netherlands and Luxemburg.

The immediate objective behind the establishment of EECwas to set up a custom union. A custom union is one whichremoves the tariff barriers within the regional trading block andfollows a common tariff policy in trading with the non-membercountries. Later on the custom union was transformed into acommon market in which not only goods and services but alsofactors of production like labour, capital, enterprise are free to movewithin the regional trading block. Later on the EEC as a commonMarket got transformed into economic Union which led to

harmonization of laws, social policy, economic, monetary, fiscalpolicies, international trade policies etc.

The following are the provisions of the treaty of Rome:-

Article 2

i) The community shall have a common market

ii) A harmonious development of economic activities within theregion.

iii) Balanced expansion of the region increase in stability, increasein the standard of living of the people of the region and the

closer relationship between the countries belonging to theregion.

Article 3

i) Elimination of custom duties and qualitative restrictions on theimport and export of goods

ii) The establishment of common commercial policy towards othercountries (non member countries)


37/256

Mcom-glob 37

iii) The abolition of all obstacles to freedom of movement forpersons, services and capital.

iv) The adoption of common policy of Agriculture.

v) The adoption of common policy of transportation.

vi) To ensure that competition in the common market is notdistorted.

vii) To coordinate the economic policies of the members of theregion and disequilibrium in the balance of payments should becorrected.

viii)The laws of the member countries of the region should beadjusted as required for the proper functioning of the CommonMarket.

ix) Improvement in employment opportunities and raising of thestandard of living.

x) The establishment of European Investment Bank to facilitate theeconomic expansion of the EEC through creation of freshresources.

xi) To promote economic and social development of the membercountries of EEC

The membership of the EEC is open to all the Europeancountries. It rose from the original Six to Nine in 1973 whenDenmark, Ireland and United Kingdom joined the community. In1981 the membership of EEC rose to ten when Greece joined thecommunity. Portugal and Spain joined the community in 1986 and

the membership of the EEC rose to twelve. In 1995 three morecountries viz. Austria, Sweden and Finland joined the EEC andthus the total membership of the community rose to fifteen.

In 1992 a Treaty of Maastricht was signed which strengthen theprocess of integration by creating a common currency w. e. f. Jan.1999. It led to making the price system and the exchange ratesystem more stabilized.

The Economic Union has built up an institutional systemwhich is unique in the world. Following are some of the mostimportant institutions:-

i) The Council of European Union:- It is a main decision makingbody of The Economic Union. It is a cluster of ministers fromeach member country of the union.

ii) European Parliament:- It is a cluster of elected members fromeach member country. It supervises the European Commission.It also shares the legislature and budgetary powers with thecouncil of the E.U.

iii) European Commission:- It is a conglomeration of thecommissioners nominated by the member countries of the E.U.


38/256

Mcom-glob 38

It is the main administrative body of E.U. which is responsiblefor day to day administration of E.U.

iv) Court of Justice:- It is the highest legal authority of E. U. Eachcountry nominates one judge to the court of Justice of E.U.

v) European Central Bank:- It is a central monetary authority of E.

U. It issues Euro notes and coins. It is a foreign exchangeauthority of E.U.

vi) Court of Auditors:- Its main function as a court of Auditors is tocheque EUs revenue and expenditure.

vii) Economic and Social Committee:- It is an authority on economicand social policy of E.U.

viii)European Committee of Regions:- The portfolio of thiscommittee is to maintain the rules, regulations and identities tothe respective regions. It is composed of representatives fromall the states of the region.

ix) European Investment Bank:- It is the financial Institution of E.U.

x) European Ombudsman:- It is an official appointed by E.U. toinvestigate peoples complaints against public organizations.

The European Union is not against globalization. Its exportsand investments are of very high order. The European Unioncontributes 1/4th of the total worlds exports which accounts forabout 15% of its GDP. As much as 40% of the foreign directinvestment (FDI) of the developed countries goes to the EuropeanUnion.

2.7 NORTH AMERICAN FREE TRADE AGREEMENT(NAFTA):-

NAFTA stands for NORTH AMERICAN FREE TRADEAGREEMENT. NAFTA is an extension of CUSTA i.e. the CanadaUnited states Trade Agreement. Though United States of Americasupported the move to form the regional trading groups like EECbut it was suspicious about its working. Therefore in 1965 theunited states of America and Canada entered into bilateral tradeagreement to eliminate tariffs on automobiles and auto-parts. In1985 both the countries decided to integrate their economiesgenerally by reducing trade barriers like tariffs gradually over aperiod of ten years. In 1989, USA and Canada formed a Free Trade

Area and hence along with goods trade in services among themwas also liberalized. It was also decided that other internalproblems like subsidies, dumping and other trade policy should besettled peacefully and friendly. However they couldnt set upcustoms union as it was difficult to have a common tariff policy withrest of the world countries or with non member countries. Canada

joined hands with America in forming Free Trade Union because itfaced with the disadvantageous situation due to following of the


39/256

Mcom-glob 39

policy of protection on the part of U.S.A. The United States ofAmerica also wanted to see that Mexico also should join theagreement and ultimately in December 1992, the three countriessigned the agreement leading to the formation of the North

American Free Trade Agreement (NAFTA). The operation ofNAFTA commenced from January 1994.

As per the provision of NAFTA all tariffs and quotas onmanufactured and agricultural goods are to be eliminated within 5to 15 years. It is called as a transitional period. Restrictions ondirect foreign investment (DFI) between the NAFTA members willbe lifted. The Intellectual Property Rights (IPRs) are to be protectedin the member countries i.e. in the NAFTA viz. U.S.A. Canada andMexico. It is expected that Chile and other Latin American countriesmay join NAFTA in future. It was decided that trade in financialservices will be liberalized by 2000.


1. What do you mean by Regional trade blocks?

2. Explain the working of European Union.

3. What do you understand by NAFTA?

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2.8 SUMMARY

1) To know economic integration we have to know economicliberalization.

2) Economic integration is a general term which covers severalkinds of arrangements by means of which two or moreindependent economies agree to come closer economically.

3) As per Timbergen, economic integration is the creation of mostdesirable structure of international economy, removing artificialbarriers to the optimum operation and introducing deliberately

all desirable elements of cooperation or unification.

4) As per Balasa, economic integration is a process and it is astate of affairs.

5) There is a distinction between economic integration andeconomic co-operation.

6) Now a days economic integration is becoming more and morepopular


40/256

Mcom-glob 40

7) United we stand, Divided we fall

8) There are as many as five major types of economic integrationwhich are as follows:-

i) Preferential Trading Agreements.

ii) Free Trade Area.iii) Customs Union.

iv) Common Market.

v) Economic Union.

9) An economic union represents a case of complete economicintegration.

10) A trade block is a cluster of nations meant for regionalisms.

11) There are following types of regional trade blocks which are as

follows:-a) Economic Union (EU)

b) North American Free Trade Agreement (NAFTA)

2.9 QUESTIONS

1) What do you mean by economic integration? What are thedifferent types of economic integration?

2) Explain the causes of the popularity of economic integration.

3) What types of economic integration would you suggest fordeveloping countries.

4) Write short notes on the following:-

a) Free Trade Area.

b) Customs Union.

c) Common Market.

d) Economic Union.

5) Explain in details the functioning of European EconomicCommunity.

6) Write a note on NAFTA.

3


41/256

Mcom-glob 41

ECONOMIC INTEGRATION II

Unit Structure:

3.0 Objectives

3.1 Asia-Pacific Economic Co-operation (APEC)

3.2 Association of South East Asian Nations (ASEAN)

3.3 South Asian Association for Regional Co-operation (SAARC)

3.4 Regionalism Vs. Multilateralism

3.5 Summary

3.6 Questions

3.0 OBJECTIVES

1. To know about Asia-Pacific Economic Co-operation2. To know about Association of South East Asian Nations

3. To know about South Asian Association for Regional Co-operation

4. To understand the difference between Regionalism andMultilateralism

3.1 ASIA-PACIFIC ECONOMIC CO-OPERATION(APEC):-

APEC stands for ASIA-PACIFIC ECONOMIC CO-OPERATION. It is a forum comprising of 18 members. Followingare the names of some of the members of the APEC forum:-

Australia, Brunel, Canada, Chile, China, New Zealand, Papus NewGuinea, Philippines, Singapore, Taiwan, Thailand, United Statesetc.

The Asia Pacific Economic Cooperation forum accounts for45 percent of Indias exports and 30% of its imports and 54% of itsforeign direct investment (EDI) Countries like Russia, India andVietnam have expressed their desire to become the members of

APEC. At the Manila Conference the APEC members decided anaction plan for a giant step forward in six areas towards free tradeamong members of APEC.

These six areas are as follows:-

i) greater overall market access.

ii) Enhancing market excess in services.

iii) Provision for open investment.

iv) Reducing the cost of business.


42/256

Mcom-glob 42

v) Building up open and efficient infrastructure sector.

vi) Strengthening economic and technical cooperation.

For strengthening the economic and technical cooperationamong member countries the APEC declaration mentionsguidelines.

The following are the goals of economic and technicalcooperation among the members of APEC:-

i) to attain sustainable growth.

ii) To reduce economic disparities.

iii) To improve wellbeing of the people.

iv) To deepen the spirits of community in the Asia-Pacific region.

It was also decided that the economic and technicalcooperation among APEC must be goal oriented. The APEC forumhas also decided to increase the membership of the forum byliberalizing trade and investment and free information technologytrade. They have also decided to develop the capital markets topromote capital flows, to mobilize domestic savings and to enhancethe environment for private investment in infrastructure. The APECdeclaration also mentions about the strengthening of economicinfrastructure especially in telecommunication, transportationenergy and also in the promotion of small business.

3.2 ASSOCIATION OF SOUTH EAST ASIANNATIONS (ASEAN):-

ASEAN stands for Association of South East Asian Nations.The origin of ASEAN goes back to ASA. ASA stands for

Association of Southeast Asia. It was proposed by Mr. Tunku AbdulRahman, the Prime Minister of Malaya in 1959. The membercountries of ASA fought among themselves due to political andterritorial disputes as a result of which ASA couldnt last long. On8th August 1967 a declaration was signed by Five south East Asiancountries viz. Indonesia, Malaysia, Philippines, Singapore, Thailandas per which the Association of South East Asian Nations (ASEAN)was formed to accelerate the economic growth of the member

countries with the spirit of equality and partnership. Brunei andVietnam joined ASEAN in 1984 and 1995 respectively. Burma andLaos joined ASEAN in 1997. United States of America supportedthe establishment of ASEAN. The establishment of ASEAN showsa move towards globalization.

ASEAN nations area of land and the population are largerthan European union comprising of 15 nations. The outstandingfeature of the economic growth strategy of ASEAN is FDI i.e.Foreign Direct Investment. Foreign trade in the life blood of


43/256

Mcom-glob 43

ASEAN. The economic prosperity and the economic integration ofASEAN depend upon two important factors viz. controlling inflationand sustained high growth rate. As regards natural resources

ASEAN is a treasure island. The aim of ASEAN is to become aFree Trade Area by reducing tariffs among the ASEAN. Inspite oftremendous political, economic and cultural diversity the ASEAN

countries are becoming integrated.

3.3 SOUTH ASIAN ASSOCIATION FOR REGIONALCO-OPERATION (SAARC)

The abbreviation, SAARC stands for The South AsianAssociation for Regional cooperation. The move to have aneconomic regional block among south Asian countries startedtaking shape from 1980. The first summit of seven south Asiancountries viz. India, Pakistan, Bangladesh, Nepal, Shri Lanka,Bhutan and Maldives took place at Dhaka in December 1985 and

the SAARC came into existence. The idea behind the formation ofSAARC was to have fearless tensionless progress and prosperityin the South Asian Association for Regional cooperation regionalgroup countries. The SAARC emerged out of the problems facedby South Asian countries. The SAARC has got over 1/5thof worldspopulation. It has only 3.3% of worlds total land area. It has amajor share of total worlds poor population. These countries canbe branded as a low per capital income countries. India is thelargest SAARC country having 2/3rd of SAARC population whileMaldives is the smallest island having population of only 3 lakhs.

Following are some of the most pressing problems faced by

SAARC countries:-

i) The very first problem faced by the SAARC countries is theBoarder dispute problem, political problem and the religiousproblem.

ii) The economies of all the seven member countries of SAARCare more or less similar. Dissimilar economies call for economicintegration.

iii) Neglect of intra-regional trade. Their exports are channelisedtowards hard currency area.

iv) Most of the SAARC member countries are exporting almost thesame types of products. For example India and Shri Lankaexport tea.

v) The economic strength of the member countries of SAARC isdifferent so is the case with economic development. Hencebenefits accrue more to the relative economically strongercountries than the relative economically poor countries was thefeeling developed amongst the SAARC countries.


44/256

Mcom-glob 44

vi) The main hurdle in the way of intra-regional trade is the scarcityof foreign exchange.

vii) These countries also face number of inadequacies liketransportation, communication etc.

The main objectives of SAARC:-

Following are the main objectives of SAARC as per Article 1 (One)of the charter of SAARC:-

i) To promote the welfare of the people of South Asia and toimprove their standard of life.

ii) To accelerate economic growth, social progress and culturaldevelopment in the region and to provide all individuals theopportunity to live in dignity and to realize their full potentials.

iii) To promote and strengthen collective self reliance among themember countries of SAARC.

iv) To contribute to mutual trust, understanding and appreciation ofeach others problems.

v) To promote active collaboration and mutual assistance in theeconomic, social, cultural, technical and scientific fields.

vi) To strengthen cooperation among themselves on matters ofcommon interest.

vii) To strengthen cooperation among other developing countries.

viii)To co-operate with international and regional organizations withsimilar aims and purposes.

Principles:-

Following are the principles laid down as per Article II of the charterof the SAARC:-

i) Co-operation within the framework of the Association shall bebased on respect for the principles of sovereign equality,territorial integrity, political independence, non-interference inthe internal affairs of other countries and mutual benefit.

ii) Such co-operation shall not be a substitute for bilateral andmultilateral co-operation but shall be comple

global trade and finance

Documents